Investing in Drilling Companies

When you’re thinking of investing in oilfield services stocks the first segment that comes to mind is that of drilling companies. Buying stocks of fracking companies and drilling companies pretty much offer a lower risk exposure to the energy sector compared to oil and gas producers. Drilling companies operate a fleet of drilling rigs used to punch holes into conventional reservoirs or tight formations that allow the extraction of oil or natural gas.

Many of Canada’s major drilling companies have a history of growth, both internally and through strategic acquisitions. Every year more than 11,000 wells are drilled and completed in the western Canadian Basin totalling more than 23 million meters. The shale revolution has resulted in an increasing number of deeper and longer horizontal wells. These wells account for more than 60% of the total number of wells drilled annually and the figure just keeps rising.

Despite the volatility in commodity prices, the long term outlook is positive for this sector as demand for petroleum is expected to rise in the coming decades. In the past few years, shale oil and gas have added thousands of barrels in new production. For example, North Dakota Bakken output averaged 75,000 barrels a day in 2007 and crossed the 700,000 barrels of oil a day in 2012.

However, oil and gas production from shale requires a higher drilling intensity as volumes decline substantially in the first year. A typical producing Bakken horizontal well sees its production decline on average 40% in the 12 months of operation. Similar scenarios apply across shale plays in North America. This creates a treadmill effect where companies have to drill more and more wells constantly every year if they wish to maintain production levels or grow it.

Here’s a few titbits on the companies listed above: Western Energy Services has a technically advance deep drilling rig fleet that benefits greatly from shale development. Xtreme Drilling & Coil mostly operates in the US liquids plays with a recently built drilling & coil tubing rig fleet. Cathedral Energy Services offers equal exposure to key conventional and unconventional plays in both Canada and the US. CanElson Drilling is a manufacturer and an operator of drilling rigs. Most of the companies above have a North American focus with an international foot print. Several companies are not pure drillers as they offer a range of services such as well servicing, equipment rentals and coiled tubing such as Precision Drilling.

Precision Drilling is one of the most active drillers in North American (click to enlarge)

Estrella is known for its Latin American focus which exposes investors to an additional set of political, regulatory and security risks. Argentina’s nationalization of YPF in 2012 dealt a blow to foreign investments in the country. Security and permitting issues in Colombia is another example of how these variables can negatively impact producers and drillers alike. These 2 countries enjoy a promising oil and gas industry yet they partially explain the weak stock charts of these stocks. This lack of geographic diversification partially explains the demise of South American focused Tuscany and Calmena peers.

The Canadian drilling sector offers a free call option on the Duvernay & Horn River shale plays. Once full scale development kicks in, the drilling companies will be the first to profit from it. It is only a matter of time before Canada adds new export markets in the near future for both oil and natural gas. In the meantime, should you decide to buy at what may be the low of the cycle, the dividend provides a decent yield.

Finally, while hydrocarbons are expected to remain an important part of our global energy landscape in the future the main risk is that of price. A substantial drop in the price of oil or gas would reduce drilling activity as producers cut back on spending. If you are looking to add a dividend paying stock to your portfolio, make sure you evaluate the balance sheet health – the total payout ratio is the key for dividend sustainability. If the company carries any debt, what is the debt to CF ratio? the lower the better. Identify which stock fits your diversification model both geographically and operationally in the number of business segments.